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Monday, November 21, 2005

portfolio accounting

I believe it's important how you account for your investments because the foundation of being able to think correctly about market prices must rest on an intuitive framework for how to account for the difference between the current market price, past market prices, and the value of the investment. This is my view. Rather than "marking to market", or holding at the lower of cost or market, or constructing a contra-asset such as depreciation, this best fits what I want to accomplish.

When I buy a stock, I'm moving assets from cash into two other assets. The first is the market price for the investment. The other is the "value beyond market price" (which would be negative if a stock is selling for more than its intrinsic value).

The market price is fairly liquid and can be converted into cash, but doing so will cause the equivalent "value beyond market price" asset to be written down to zero. It can be used as collateral to secure debt. It is widely recognized as an asset.

The "value beyond market price" is an intangible asset which is much lower on the balance sheet and should probably be considered a non-current asset since it's not particularly likely to be converted into cash in less than one year (technically it's one business cycle, but who's counting). This asset can't be converted into cash, it can't be used as collateral for anything, and most people don't recognize it as an asset. Why would they? They could buy the stock for the market price alone. But on my own balance sheet, I recognize it as an asset.

The market will unpredictably shift assets between these two accounts, independent of anything I do. Unpredicted changes in the business will cause the "value beyond market price" to increase or decrease. I've had cases where it went from positive to negative in which case I dumped the stock ASAP.

I like this approach because it helps keep these two things very separate. And it's easy to imagine changes in value affecting a single asset rather than both an asset and its associated contra-asset, although using a contra-asset is a lot more GAAP-like.

But this is no replacement for the Mr. Market analogy, which I find very useful.

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